The Transformation of Microsoft

In early 2015, Microsoft CFO Amy Hood and the rest of the senior leadership team faced a fundamental choice. Was the company ready to invest in long-term growth at the expense of some short-term profit margins? Professor Fritz Foley discusses how leadership faced these difficult decisions, and worked to get investors and employees on board.

Brian Kenny: Electronics enthusiasts in the 1970s looked forward to it every year, the January issue of Popular Electronics that is, because that issue was known for featuring the coolest up-and-coming products in the world of electronics. When the January 1975 issue hit newsstands it did not disappoint. The cover was adorned with the first available image of the Altair 8800, the world's first mini-computer kit. It may not have been the shot heard round the world, but many say that it was the spark that ignited the home computer revolution. That very magazine inspired a young Paul Allen and Bill Gates to turn their passion for computers into a business that subsequently became an empire. Today, Microsoft Corporation is the third most valuable company in the world and the world's largest software company. After four decades of buffeting the headwinds of the very industry it helped to create, Microsoft is at a turning point. The way forward is not entirely clear.

Professor Foley's research focuses on corporate finance. He's an expert on investment, capital structure, working capital management, and a range of related topics, all of which probably factor into the case today. Fritz, thanks for joining us.

Fritz Foley: Thanks so much for having me.

Kenny: Could you set the stage for us. How does the case begin? Who's the protagonist and what's on her mind?

Foley: The protagonist is Amy Hood, who is Microsoft's CFO. She also was a student here at HBS at the time that I was in the PhD program, so I've known her for some time. She is facing a set of choices that revolve around whether or not Microsoft should try to pursue increased margin or increased growth.

Kenny: What prompted you to write the case? Your connection with Amy obviously is part of that, but why Microsoft and why now?

Foley: I think I have been struck by the transformation that they are in the midst of. This is a company that, it's hard to remember this, in the early 2000s the stock price was stuck in the $20 to $30 a share range. There was a group of people who were calling for the firm to be managed essentially for cash distributions and for increased margins. And then there were some growth opportunities the company faced simultaneously. There was a real choice as to what direction to head. I think this is a compelling choice that many other companies face. It's a powerful example for me to highlight in a course I teach about chief financial officers.

"It was an environment where there were high [personal] returns to showing that you were the smartest person in the room"

Kenny: Microsoft was the first player on this stage, really, but then Apple came along. I think many people look at these two as fierce competitors, but can you just talk about sort of the difference between them in terms of how they managed their financial strategy?

Foley: At one level they certainly are similar. They're in the tech space. In fact, many things that Microsoft was attracted to, phones in particular, is something that Apple has excelled at. I think that at the time of the case they were quite different in the eyes of investors. I would say investors still viewed Apple as having a lot of a growth emphasis, a commitment to innovating new products, and solving problems that people weren't even sure they had. Whereas, Microsoft was the older, more established tech firm that I think in the eyes of some had become, not a relic of the past but less relevant when thinking about future innovations. In some [ways] the case is about how Microsoft tried to shed that view and become a relevant, growth-oriented entity again.

Kenny: They'd certainly been criticized over the decades for not moving quickly enough to innovate, and kind of getting caught up in their own... You think about IBM as a company that faced similar criticisms, getting caught up in just their size and the bureaucracy of the place. What did Microsoft's business look like in 2012? That seemed to be the sort of beginning of the turning point.

Foley: It was one where there was varying performance across divisions. There was interest by value activist investors, given the large cash holdings that the firm had. Obviously, their market share when it came to the Office suite of products and Windows, those were quite high and they were obviously very successful in continuing to provide versions of that to a whole variety of users. They had an emerging cloud business, but it wasn't clear that they would win in that space. They really struggled in other spaces. In search, Bing never got traction relative to Google. In phones, they were really was struggling in 2012. It's right before they tried to make more headway in phones by buying Nokia, which also subsequently didn't work out as well as they had hoped.

I think along the series of dimensions they were really trying to get some traction, trying to get footing in new spaces. There were a group of investors that actually felt like that wasn't what they should do, that they should just focus on Office, focus on Windows, enjoy the high margins that came with their on-premises server and tool business offerings. They faced some really hard choices.

Kenny: They were also, in terms of the organization itself, up against some issues. What were some of the things they were encountering [with their culture] at the time?

Foley: It's a fascinating story from a cultural standpoint. It was an environment where there were high [personal] returns to showing that you were the smartest person in the room. Some of the stories that I have heard are a little jarring. I am not sure I would've survived in this environment.

There were these six week mid-year reviews that took place and were incredibly demanding. It was an environment that was beginning to really emphasize the desire to be efficient, to be right. In fairness to them, their culture came from a place where they were selling a product that couldn't really fail. People had very high expectations for the performance of everything Microsoft provided them. Unlike today, where there's more room to update things through online updates. {Then], a lot of the software had to be close to perfect when it shipped.

Kenny: Actually, I can remember a time when the launch of a new Widows system was similar to the launch of a new iPhone. People were really excited to get the new system, but inevitably there were bugs, and those were highly publicized. They fell under a lot of criticism. They were really operating under a microscope for a long time.

Foley: For sure, and were keenly aware that time to fail in their products, which is a measure of how long it took for some product or process to break down, had to be very long, otherwise they would meet with a lot of customer dissatisfaction.

Kenny: Let's move into the transformation phase for them. What was the sort of fundamental shift they made in terms of changing or restructuring the organization?

Foley: In my view, I think that they did a variety of things to adopt more of a growth orientation. Some of this dealt with their metrics, some of it dealt with very explicit changes to the culture. I think some of it also dealt with a realization that pursuing growth would enhance value much more than trying to increase margins or larger dividend payouts to shareholders. This was in the 2012, 2013 timeframe when we began to see pieces of this. They also faced significant managerial changes at that time. That's when Steve Ballmer retired and they needed to pick a new CEO. Could've gone a variety of directions there. By picking Satya Nadella, they effectively were committing to more of a growth path.

Kenny: These choices are both potentially successful, but there are tradeoffs I would guess.

Foley: It's a very hard tradeoff to make. In teaching my MBA students and executive education students ... I ask them, "Would you sacrifice some margin for growth?" I'm always struck how hard that question can be and how many people don't have much intuition for it. Other companies dogo the margin route.

"Many people find it easier to see the benefits that come with cutting costs and looking for efficiencies, and worry that what may come with growth could be elusive"

Kenny: Is it a situation where the margin choice is one that's probably more comfortable and returns are going to come sooner? And the growth choice is a little riskier, and for a risk-averse culture probably harder to implement and you're betting on the future. Is that fundamentally what the choice is?

Foley: I think that's a really good way of putting it. Many people find it easier to see the benefits that come with cutting costs and looking for efficiencies, and worry that what may come with growth could be elusive. I have heard senior finance managers say that they had to earn the permission to go after growth. They have to get the buy-in from a group of investors who feel as if the senior leadership team has credibility in pursuing growth.

Kenny: Yes, and here we have Microsoft, an enormous company, 130,000 or so employees, about to pursue an option that is in many ways counter to the culture of the organization. How do you do that? How do you cascade this kind of a change through an organization of that size?

Foley: On the cultural side, one thing that they did was very explicitly adopt a growth-mindset culture. Satya Nadella writes about this in his recent book, Refresh. The story is for me very compelling. It's incredibly hard to get any organization to change its culture. Whenever I've been a part of an organization that tried to engage in a cultural shift, whatever the tagline was quickly became the punchline for office jokes.

Kenny: I've been on the other side of that. I'm the guy who writes the [taglines]most often, so ...

Foley: So you know how hard this is. I think that they were very wise in picking Kathleen Hogan, who had led one of the divisions of Microsoft, to head up the charge to describe and roll out this cultural change. They brought senior leaders on board. Ultimately I think there was a lot of demand for it, that many people who were working at Microsoft were innovative engineers and a very creative set of employees who wanted to pursue growth.

When given the choice to move away from the six-week midyear review processes, and given the opportunity to go to meetings where they didn't feel like they had to be exactly right in making a point but could stimulate the beginning of a discussion, a set of ideas that could lead to something that was new, people embraced that.

Kenny: And here we are in the age of the millennial worker. Millennials don't want to work for the old Microsoft for sure, and Microsoft is competing with the likes of Google and Apple and other firms that are definitely perceived as open and innovative. They want people with energy and ideas, so they have to adopt that same personalty, I guess.

Foley: Yes, I agree with that. I think there's a new buzz about Microsoft, at least among my students. They're much more intrigued by what it would mean to work there and what opportunities exist to do some things that would be truly novel and have a big impact on how people get work done.

Kenny: Let's go back to our protagonist, Amy Hood. The case delves into her mindset a little bit. She's getting ready to communicate these changes to the financial community. What are the kinds of things a CFO would have to think about? I imagine the financial community probably would be more comfortable with the margin choice than the growth choice.

Foley: It's fun for me to imagine her faced with this choice really of, okay, if I go down this path of growth, I am going to have to go to my investors and say, "Our margins are going to go down for some period of time, and you're not going to like that."

Foley: But there's going to be some upside, [but] it will take some time for that upside to show up. So I think she needed to find ways to communicate or signal what that upside would be and how big it might be to the investors so she wouldn't lose credibility with them and would have the permission essentially to pursue growth.

Kenny: We hear all the time about the emphasis on the short term, short termism. in the financial community. People want returns and they want them right away. In your experience are you seeing a shift in that in the financial community? Are the analysts getting a little more comfortable with this notion of you can't always go for the margins, you've got to find some sustainable growth in the long-term?

Foley: It's a great question. It's one that ... I think about with our financial system generally. I'm probably more optimistic relative to many...

There's a big burden on senior finance teams to explain how value is created by thinking long term and embracing growth opportunities. In some sense when I look at what Amy has been doing at Microsoft I applaud her and her team for taking on that challenge. They quite explicitly set a target of a $20 billion run rate for their commercial cloud business. Once analysts had that number they could begin to build off of it and get a feel for how much value could be created if Microsoft succeeded at pulling this off.

"I'm hopeful that finance teams and organizations will play a role in educating analysts as to how they should think about the future when growth opportunities exist and are attractive"

By having the courage to commit to that path and help analysts understand what the path meant, I think they have been effective in pursuing it.

Foley: More generally, I do worry that there are some analysts that simply take an earnings per share number and apply some current multiple and don't think much about what the future will look like. I'm hopeful that finance teams and organizations will play a role in educating analysts as to how they should think about the future when growth opportunities exist and are attractive.

Kenny: You mentioned earlier that you've talked about this in class. Do MBA students come at this differently than the executive education students who have been in fiduciary roles in organizations already?

Foley: That's an interesting question. Let me reflect on that for a moment. I think the approach is fairly similar. I would say that some MBA students are probably less aware of the constraints that capital markets may put on senior management teams who pursue growth. They're less aware of what an activist who wants cash now might push management to do. Executive students tend to be keenly aware of those pressures.

Foley: If anything, I find that MBA students ... It's a little bit harder for them to articulate what is the case for pursuing margin for Microsoft in 2012, 2013. Many executive education students are quick to come up with lists of things that could be done strategically financially in picking leadership.

Kenny: Fritz, thanks for joining us today.

Foley: Thanks very much for having me.

Kenny: If you enjoyed this episode of Cold Call, subscribe on iTunes for more cases like this one, and please, write a review. I'm your host, Brian Kenny, and you've been listening to Cold Call, an official podcast of Harvard Business School.

Brian Kenny: Electronics enthusiasts in the 1970s looked forward to it every year, the January issue of Popular Electronics that is, because that issue was known for featuring the coolest up-and-coming products in the world of electronics. When the January 1975 issue hit newsstands it did not disappoint. The cover was adorned with the first available image of the Altair 8800, the world's first mini-computer kit. It may not have been the shot heard round the world, but many say that it was the spark that ignited the home computer revolution. That very magazine inspired a young Paul Allen and Bill Gates to turn their passion for computers into a business that subsequently became an empire. Today, Microsoft Corporation is the third most valuable company in the world and the world's largest software company. After four decades of buffeting the headwinds of the very industry it helped to create, Microsoft is at a turning point. The way forward is not entirely clear.

Professor Foley's research focuses on corporate finance. He's an expert on investment, capital structure, working capital management, and a range of related topics, all of which probably factor into the case today. Fritz, thanks for joining us.

Fritz Foley: Thanks so much for having me.

Kenny: Could you set the stage for us. How does the case begin? Who's the protagonist and what's on her mind?

Foley: The protagonist is Amy Hood, who is Microsoft's CFO. She also was a student here at HBS at the time that I was in the PhD program, so I've known her for some time. She is facing a set of choices that revolve around whether or not Microsoft should try to pursue increased margin or increased growth.

Kenny: What prompted you to write the case? Your connection with Amy obviously is part of that, but why Microsoft and why now?

Foley: I think I have been struck by the transformation that they are in the midst of. This is a company that, it's hard to remember this, in the early 2000s the stock price was stuck in the $20 to $30 a share range. There was a group of people who were calling for the firm to be managed essentially for cash distributions and for increased margins. And then there were some growth opportunities the company faced simultaneously. There was a real choice as to what direction to head. I think this is a compelling choice that many other companies face. It's a powerful example for me to highlight in a course I teach about chief financial officers.

"It was an environment where there were high [personal] returns to showing that you were the smartest person in the room"

Kenny: Microsoft was the first player on this stage, really, but then Apple came along. I think many people look at these two as fierce competitors, but can you just talk about sort of the difference between them in terms of how they managed their financial strategy?

Foley: At one level they certainly are similar. They're in the tech space. In fact, many things that Microsoft was attracted to, phones in particular, is something that Apple has excelled at. I think that at the time of the case they were quite different in the eyes of investors. I would say investors still viewed Apple as having a lot of a growth emphasis, a commitment to innovating new products, and solving problems that people weren't even sure they had. Whereas, Microsoft was the older, more established tech firm that I think in the eyes of some had become, not a relic of the past but less relevant when thinking about future innovations. In some [ways] the case is about how Microsoft tried to shed that view and become a relevant, growth-oriented entity again.

Kenny: They'd certainly been criticized over the decades for not moving quickly enough to innovate, and kind of getting caught up in their own... You think about IBM as a company that faced similar criticisms, getting caught up in just their size and the bureaucracy of the place. What did Microsoft's business look like in 2012? That seemed to be the sort of beginning of the turning point.

Foley: It was one where there was varying performance across divisions. There was interest by value activist investors, given the large cash holdings that the firm had. Obviously, their market share when it came to the Office suite of products and Windows, those were quite high and they were obviously very successful in continuing to provide versions of that to a whole variety of users. They had an emerging cloud business, but it wasn't clear that they would win in that space. They really struggled in other spaces. In search, Bing never got traction relative to Google. In phones, they were really was struggling in 2012. It's right before they tried to make more headway in phones by buying Nokia, which also subsequently didn't work out as well as they had hoped.

I think along the series of dimensions they were really trying to get some traction, trying to get footing in new spaces. There were a group of investors that actually felt like that wasn't what they should do, that they should just focus on Office, focus on Windows, enjoy the high margins that came with their on-premises server and tool business offerings. They faced some really hard choices.

Kenny: They were also, in terms of the organization itself, up against some issues. What were some of the things they were encountering [with their culture] at the time?

Foley: It's a fascinating story from a cultural standpoint. It was an environment where there were high [personal] returns to showing that you were the smartest person in the room. Some of the stories that I have heard are a little jarring. I am not sure I would've survived in this environment.

There were these six week mid-year reviews that took place and were incredibly demanding. It was an environment that was beginning to really emphasize the desire to be efficient, to be right. In fairness to them, their culture came from a place where they were selling a product that couldn't really fail. People had very high expectations for the performance of everything Microsoft provided them. Unlike today, where there's more room to update things through online updates. {Then], a lot of the software had to be close to perfect when it shipped.

Kenny: Actually, I can remember a time when the launch of a new Widows system was similar to the launch of a new iPhone. People were really excited to get the new system, but inevitably there were bugs, and those were highly publicized. They fell under a lot of criticism. They were really operating under a microscope for a long time.

Foley: For sure, and were keenly aware that time to fail in their products, which is a measure of how long it took for some product or process to break down, had to be very long, otherwise they would meet with a lot of customer dissatisfaction.

Kenny: Let's move into the transformation phase for them. What was the sort of fundamental shift they made in terms of changing or restructuring the organization?

Foley: In my view, I think that they did a variety of things to adopt more of a growth orientation. Some of this dealt with their metrics, some of it dealt with very explicit changes to the culture. I think some of it also dealt with a realization that pursuing growth would enhance value much more than trying to increase margins or larger dividend payouts to shareholders. This was in the 2012, 2013 timeframe when we began to see pieces of this. They also faced significant managerial changes at that time. That's when Steve Ballmer retired and they needed to pick a new CEO. Could've gone a variety of directions there. By picking Satya Nadella, they effectively were committing to more of a growth path.

Kenny: These choices are both potentially successful, but there are tradeoffs I would guess.

Foley: It's a very hard tradeoff to make. In teaching my MBA students and executive education students ... I ask them, "Would you sacrifice some margin for growth?" I'm always struck how hard that question can be and how many people don't have much intuition for it. Other companies dogo the margin route.

"Many people find it easier to see the benefits that come with cutting costs and looking for efficiencies, and worry that what may come with growth could be elusive"

Kenny: Is it a situation where the margin choice is one that's probably more comfortable and returns are going to come sooner? And the growth choice is a little riskier, and for a risk-averse culture probably harder to implement and you're betting on the future. Is that fundamentally what the choice is?

Foley: I think that's a really good way of putting it. Many people find it easier to see the benefits that come with cutting costs and looking for efficiencies, and worry that what may come with growth could be elusive. I have heard senior finance managers say that they had to earn the permission to go after growth. They have to get the buy-in from a group of investors who feel as if the senior leadership team has credibility in pursuing growth.

Kenny: Yes, and here we have Microsoft, an enormous company, 130,000 or so employees, about to pursue an option that is in many ways counter to the culture of the organization. How do you do that? How do you cascade this kind of a change through an organization of that size?

Foley: On the cultural side, one thing that they did was very explicitly adopt a growth-mindset culture. Satya Nadella writes about this in his recent book, Refresh. The story is for me very compelling. It's incredibly hard to get any organization to change its culture. Whenever I've been a part of an organization that tried to engage in a cultural shift, whatever the tagline was quickly became the punchline for office jokes.

Kenny: I've been on the other side of that. I'm the guy who writes the [taglines]most often, so ...

Foley: So you know how hard this is. I think that they were very wise in picking Kathleen Hogan, who had led one of the divisions of Microsoft, to head up the charge to describe and roll out this cultural change. They brought senior leaders on board. Ultimately I think there was a lot of demand for it, that many people who were working at Microsoft were innovative engineers and a very creative set of employees who wanted to pursue growth.

When given the choice to move away from the six-week midyear review processes, and given the opportunity to go to meetings where they didn't feel like they had to be exactly right in making a point but could stimulate the beginning of a discussion, a set of ideas that could lead to something that was new, people embraced that.

Kenny: And here we are in the age of the millennial worker. Millennials don't want to work for the old Microsoft for sure, and Microsoft is competing with the likes of Google and Apple and other firms that are definitely perceived as open and innovative. They want people with energy and ideas, so they have to adopt that same personalty, I guess.

Foley: Yes, I agree with that. I think there's a new buzz about Microsoft, at least among my students. They're much more intrigued by what it would mean to work there and what opportunities exist to do some things that would be truly novel and have a big impact on how people get work done.

Kenny: Let's go back to our protagonist, Amy Hood. The case delves into her mindset a little bit. She's getting ready to communicate these changes to the financial community. What are the kinds of things a CFO would have to think about? I imagine the financial community probably would be more comfortable with the margin choice than the growth choice.

Foley: It's fun for me to imagine her faced with this choice really of, okay, if I go down this path of growth, I am going to have to go to my investors and say, "Our margins are going to go down for some period of time, and you're not going to like that."

Foley: But there's going to be some upside, [but] it will take some time for that upside to show up. So I think she needed to find ways to communicate or signal what that upside would be and how big it might be to the investors so she wouldn't lose credibility with them and would have the permission essentially to pursue growth.

Kenny: We hear all the time about the emphasis on the short term, short termism. in the financial community. People want returns and they want them right away. In your experience are you seeing a shift in that in the financial community? Are the analysts getting a little more comfortable with this notion of you can't always go for the margins, you've got to find some sustainable growth in the long-term?

Foley: It's a great question. It's one that ... I think about with our financial system generally. I'm probably more optimistic relative to many...

There's a big burden on senior finance teams to explain how value is created by thinking long term and embracing growth opportunities. In some sense when I look at what Amy has been doing at Microsoft I applaud her and her team for taking on that challenge. They quite explicitly set a target of a $20 billion run rate for their commercial cloud business. Once analysts had that number they could begin to build off of it and get a feel for how much value could be created if Microsoft succeeded at pulling this off.

"I'm hopeful that finance teams and organizations will play a role in educating analysts as to how they should think about the future when growth opportunities exist and are attractive"

By having the courage to commit to that path and help analysts understand what the path meant, I think they have been effective in pursuing it.

Foley: More generally, I do worry that there are some analysts that simply take an earnings per share number and apply some current multiple and don't think much about what the future will look like. I'm hopeful that finance teams and organizations will play a role in educating analysts as to how they should think about the future when growth opportunities exist and are attractive.

Kenny: You mentioned earlier that you've talked about this in class. Do MBA students come at this differently than the executive education students who have been in fiduciary roles in organizations already?

Foley: That's an interesting question. Let me reflect on that for a moment. I think the approach is fairly similar. I would say that some MBA students are probably less aware of the constraints that capital markets may put on senior management teams who pursue growth. They're less aware of what an activist who wants cash now might push management to do. Executive students tend to be keenly aware of those pressures.

Foley: If anything, I find that MBA students ... It's a little bit harder for them to articulate what is the case for pursuing margin for Microsoft in 2012, 2013. Many executive education students are quick to come up with lists of things that could be done strategically financially in picking leadership.

Kenny: Fritz, thanks for joining us today.

Foley: Thanks very much for having me.

Kenny: If you enjoyed this episode of Cold Call, subscribe on iTunes for more cases like this one, and please, write a review. I'm your host, Brian Kenny, and you've been listening to Cold Call, an official podcast of Harvard Business School.